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EA Misses on Earnings in 4Q

Electronic Arts Inc. (EA - Free Report) reported non-GAAP earnings per share of 55 cents in the fourth quarter of 2013, up significantly from 17 cents per share earned in the year-ago quarter. The year-over-year increase was primarily attributed to higher revenues and margin expansion.

However, including stock-based compensation, earnings came in at 41 cents, which lagged the Zacks Consensus Estimate of 51 cents per share.

Revenues

Non-GAAP revenues increased 6.4% year over year to $1.04 billion, primarily due to robust revenue growth from the digital segment. Reported revenue failed to beat management’s guided range of $1.025 billion to $1.125 billion and also missed the Zacks Consensus Estimate of $1.107 billion, primarily due to lower-than-expected sales of Crysis 3 and Dead Space 3.

Robust growth in EA’s Digital revenues (up 45.4% year over year) and Distribution (up 13.0% year over year) more than offset the 25.1% year-over-year decline in revenues from EA’s Publishing segment.

The growth in digital revenues were fueled by a 65% increase in full game downloads where SimCity played a crucial part. Moreover, extra content and free-to-play revenues increased 45.0% on a year-over-year basis primarily driven by FIFA Ultimate Team, Star Wars: The Old Republic and Bejeweled Blitz. EA’s mobile business also recorded 21.0% year-over-year jump in revenues. Additionally, advertising and other digital revenue also contributed to the 54% increase in revenues.

Region wise, North American sales (42.0% of total revenue) decreased 6% year over year to $437.0 million. Sales from Europe (54% of total revenue) increased 27.0% year over year to $557.0 million. Asia (4% of total revenue) plunged 36% from the year-ago quarter to reach $46.0 million in the reported quarter.

Margins

EA’s non-GAAP gross margin expanded 970 basis points year over year to 74.6% while gross profit increased 22.5% during the same period to $773 million. The solid margin expansion was primarily led by higher subscriptions from Battlefield 3 Premium and reduction in online support cost.

Operating expenses, as a percentage of revenue, declined to 51.9% in the fourth quarter from 56.7% in the year-ago quarter. Including stock-based compensation, the percentage decline was 490 basis points (bps).

These reductions in costs led to a substantial increase in operating income for EA. On a non-GAAP basis, EA’s operating income increased to $233.0 million up from $77 million in the year-ago quarter. Including stock-based compensation, operating income came in at $191.0 million versus $36.0 million in the year-ago quarter.

EA’s non-GAAP net income came in at $169 million which was up from $56 million while net margin came at 16.3% compared to 5.7% in the year-ago quarter. Including stock based compensation of $42 million, EA reported net income of $127 million.

Balance Sheet and Cash Flow

EA exited the quarter with $1.68 billion in cash, short-term investments and marketable securities compared with $1.43 billion in the previous quarter. Cash flow from operations was $233.0 million compared to $363.0 million in the previous quarter. During the reported quarter, EA repurchased 1 million shares for $13.0 million.

Outlook

For the first quarter of 2014, EA expects to generate non-GAAP revenues of approximately $450.0 million. EA expects non-GAAP loss per share to be 62 cents, wider than the Zacks Consensus Estimate of a loss of 46 cents. Non-GAAP operating expense is expected to be $530.0 million.

The company also provided fiscal 2014 guidance. EA expects to generate non-GAAP revenues of approximately $4.0 billion. Packaged goods revenue is expected to increase 7% year over year, driven by Battlefield 4 while digital revenues is expected to increase 4% year over year. The gross margin is expected to be 66% due to higher mix of packaged goods revenues. EA expects its non-GAAP earnings to be $1.20 per share, higher than the Zacks Consensus Estimate of 67 cents.

EA has planned to release 11 titles in 2014, which includes Battlefield 4 and the Sims 4. The company is expected to release 15 mobile titles for Apple’s (AAPL - Free Report) iOS and Google’s Android platforms.

Recommendation

We believe that EA’s strong digital portfolio and continuing growth in the free-to-play and online segment will drive top-line growth going forward. Moreover, the company’s efforts to optimize costs through overhead reductions will be beneficial going forward. The company’s licensing agreement with Walt Disney (DIS - Free Report) to publish and market games based on Star Wars should also act in favor, as it will be gaining a new IP and a franchise.

However, we believe that EA faces a number of headwinds that include a soft video game industry performance, particularly due to weakness in retail sales amid an aging console system lifecycle. Competition from other game makers is also a headwind going forward.

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